The negative relationship between economic performance and a bloated public sector also has been confirmed by research from other places not often associated with libertarian thought, including Harvard and Sweden.

Europe suffers from a growth slowdown. The GDP growth in Europe has lagged behind the GDP growth in the US and has been far worse than the GDP growth in the NIC countries, particularly China… However, what is the reason for slow or rapid economic growth? …In many respects, the labour market plays the key role in the economy because it determines both the use of the labour input and the level of overall competitiveness of a nation. Obviously, the functioning of the labour market is not independent of the public sector. A large government is almost inevitably associated with a large tax wedge, and the functioning of the labour market appears to be critically dependent on the size of the tax wedge. It may be fair to say that the harmful consequences of a high tax wedge are exceptionally well and unambiguously documented in the literature. …On the basis of the estimates derived in this study, the following guide for growth policies appears to be warranted: …Do not over-expand the welfare state. Larger governments are associated with slower growth rates.

Gee, that sounds quite familiar. Where have we come across this notion that big government has a negative impact on growth? Sounds a lot like the Rahn Curve.

Indeed, the paper makes another point that is very consistent with the Rahn Curve.

As this simple chart illustrates, the Rahn Curve is sort of the spending equivalent of the Laffer Curve.

Except government spending is on the horizontal axis and economic performance is on the vertical axis.

The ideal outcome is for government to be kept small so that economic output is at its maximum point. The academic literature suggests that prosperity is at its peak level when the burden of government spending is about 20 percent of GDP.

I actually disagree with those numbers, and I think they are the result of data constraints. Researchers looking at the post-World War II data generally find that Hong Kong and Singapore have the maximum growth rates, and the public sector in those jurisdictions consumes about 20 percent of economic output. Nations with medium-sized governments, such as Australia and the United States, tend to grow a bit slower. And the bloated welfare states of Europe suffer from stagnation.

So it’s understandable that academics would conclude that growth is at its maximum point when government grabs 20 percent of GDP. But what would the research tell us if there were governments in the data set that consumed 15 percent of economic output? Or 10 percent, or even 5 percent?

But I’m digressing. Let’s get back to the research from the Bank of Finland. The author makes a very sensible point that even modest reductions in the burden of government can yield positive results – sort of like going from Point A to Point B on the Rahn Curve.

…a revolution is not required to generate one per cent of additional growth each year: the “welfare state” does not need to be eliminated, wages do not need to be lowered to subsistence income levels, and working hours do not need to be increased to medieval levels. In fact, in most instances, significant improvements in economic growth could be produced by simply reverting to the conditions of approximately one decade ago. …by reducing the growth of the public sector and decreasing tax rates, one may increase both the labour supply and the competitiveness of the private sector. The future development of the public sector is indeed the key aspect of determining the future development of the economy. If the public sector can be maintained in a reasonable fashion, one may manage to achieve low tax rates and low tax wedges in labour markets, and one can also avoid fiscal crises and keep the risk premia (of interest rates) low.

All we really need to do is give the private sector some breathing room, which is the point I make in this interview with Larry Kudlow. I was talking about the regulatory burden, but my argument is equally applicable to fiscal policy.

This doesn’t exactly get us to our libertarian Nirvana, of course, so I realize that “breathing room” isn’t the most inspirational motto.

But it should help us understand that the fight isn’t over. I certainly haven’t given up.*

The Laffer curve for tomorrow is a straight line. Nobody is going to quit work immediately, tomorrow, if tax rates rise to 90%.

But a few will quit in a week, more in a month, a significant proportion by the end of the year.
Also, as flatter effort-reward curves decrease motivation and the country loses top worldwide competitiveness, many workers “will be quitted” as American companies get outcompeted in the international marketplace – but that takes even longer. This process has a bit of inertia in it – but less and less as the world moves faster and faster.

Even longer term are the lifetime decisions towards more mediocrity under the flatter-effort reward curves of the welfare state and the futility of attempting entrepreneurship (since new companies are likely to be outcompeted in the global marketplace by environments that have more motivating effort-reward curves). Each process has a different inertia and the ones with the heaviest inertia are the ones that are impossible to reverse.

What I’m getting to is that it is meaningless to talk about a particular Laffer Curve shape, without mentioning an associated time horizon.

The Laffer curve for tomorrow is a straight line, the Laffer curve for a week starts bending downwards, Laffer Curve for the next year bends even more downwards, five years even more etc. For the long term, Zorba’s Corollary applies:

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That is simply an expression of the fact that, in the long term, all other factors affecting prosperity are dwarfed by the relentless compounding of growth rates (or lack thereof).

[…] P.S. Just in case you’re under the impression that only cranky libertarians think government is too big in Europe, I invite you to peruse this research from the European Central Bank, World Bank, and National Bank of Finland. […]

[…] P.S. Just in case you’re under the impression that only cranky libertarians think government is too big in Europe, I invite you to peruse this research from the European Central Bank, World Bank, and National Bank of Finland. […]

[…] We can still enjoy good growth so long as we strive to at least move in the right direction. As I explained back in 2012, the private sector is capable of producing impressive results so long as it has sufficient […]

[…] libertarian perfection would be nice, but the free market is capable of generating good results even if policy is merely decent. Almost all European nations have excessive taxes and spending, for instance, but they compensate […]